Sole Member Nonprofits Complicate Directors’ Fiduciary Duties

Nonprofit board members face special challenges when a corporate entity is designated the sole member of nonprofit. As evident in recent legislation enacted in New York State at the end of 2018 that prohibited individuals from being the sole members of New York nonprofits, there are unique risks to structures where a tax-exempt entity’s board is effectively controlled by other entities or individuals.

While New York’s new law doesn’t affect nonprofits that are controlled by other nonprofits[i], the reasoning for New York’s change is instructive. It grew out of regulators’ and lawmakers’ concerns that a sole member structure is susceptible to abuse – a nonprofit controlled by one or two people is more likely to engage in self-dealing or private benefit transactions, both of which are prohibited under state and federal law.

New York’s restrictions on sole member structures comes at a time when charities regularly use corporate sole member structures as part of a variety of major transactions and strategies. Typically, the arrangement is used by a large, well-funded nonprofit that is either (i) forming a new entity in which to house a new activity, or (ii) taking control of an existing nonprofit.

A nonprofit sole member structure puts directors of the subsidiary in a challenging position because their fiduciary duties to the nonprofit can sometimes put them at odds with the interests and direction of the sole member. Below I walk through:  (i) what is a sole member structure; (ii) how sole member nonprofits are useful; (iii) when implementing a sole member structure, what are some challenges; and (iv) suggestions to help implement a sole member structure.

What is a sole member nonprofit?

Modern nonprofits are typically run by a board of directors that is self-sustaining – that means the board elects new directors to fill empty board seats. Historically, however, a nonprofit was a membership corporation and the “members” were responsible for electing the board. Who the “members” differed from organization to organization, but the members met at least annually and took an active role in electing the board of the organization. A good modern analogue is a labor union – the membership is active in electing the leadership, so even though the Board is still responsible for overseeing the union’s activities, the members can keep the Board in check. A membership structure parallels the shareholder structure of a for-profit corporations, where shareholders elect directors to the Board but are removed from the corporation’s day-to-day operations.

Many states’ laws still allow one person, or one corporation, to be the “sole member” of a nonprofit, retaining the right to elect and remove directors. There is no federal prohibition against that structure, provided that the controlled nonprofit and its Board observe all of the other rules applicable to 501(c)(3) organizations. The sole member structure, therefore, has been popular as a way to give individuals or large nonprofits the ability to keep control over a subsidiary nonprofit.

How are sole member nonprofits useful?

A sole member structure is really appealing when an individual or corporation creates a new nonprofit and wants to retain long term control over the nonprofit’s mission and activities. By making themselves the sole member, the founder can give themselves the power to appoint or remove board members. This allows the sole member to have a veto power over board decisions that the sole member disagrees with – they can always remove (or threaten to remove) board members who vote against the sole member’s interests.

Most founders use this veto power for good. The founder, who is passionate about the organization and its mission, is especially sensitive to mission creep. If they sense that board members are not pulling their weight or are moving the nonprofit in the wrong direction, the sole member can appoint new board members and remove the bad ones to get the nonprofit back on track.

Another scenario where we often see a sole member structure is a small nonprofit that is approaching an inflection point and is in need of assistance.  Enter a large financially-healthy nonprofit, able to take over back office and administrative functions for the smaller nonprofit. Both organizations recognize that the smaller nonprofit has developed goodwill, so they don’t want to just absorb the smaller nonprofit’s programs into the larger nonprofit – there’s a benefit to keeping the smaller organization as a separate legal entity, with its “brand” and support intact. The larger nonprofit’s board may also want to protect the larger nonprofit from liability by maintaining the separate legal entity.

Transaction costs are also much smaller in a change of control transaction involving a sole member compared to a traditional merger or acquisition – a sole member transition often requires little more than a minor revision to the bylaws to provide for a sole member. A formal merger with, or transfer of assets to, a larger nonprofit often requires regulatory approval and generally entails more legal fees and staff time to implement.

A third situation where we often see a sole member structure used is where a large nonprofit identifies a new market – either a new location where its programs can succeed, or a new type of program the nonprofit would like to implement. If the new market creates new types of legal or financial exposure, the large nonprofit might want to insulate itself by housing the new venture in a separate legal entity.[ii] The large nonprofit, to encourage the small nonprofit to be self-sufficient, could set the new nonprofit up as a separate 501(c)(3) public charit with its own board and staff. While there may be some start-up support, the goal is often to have the large nonprofit’s input be limited to high-level oversight and the appointment of the board members each year. The large nonprofit can ensure there’s no mission creep through its control of the board of the new nonprofit, but it owes no legal duty to the smaller nonprofit.

When implementing a sole member structure, avoid key pitfalls

Sole member structures can be very useful, especially when trying to quickly take over a nonprofit or when structuring a new organization to ensure it can be controlled going forward. It can also be an intermediary step to a full merger transaction.  But let’s step back for a minute to consider some of the practical and legal issues that can arise with sole member structures.

Donor Confusion

Donors want to know where their money and support is going. They want to feel like they understand the values of the organization they support and who is responsible for making decisions. That’s why nearly every nonprofit website includes an “About Us”, “Board”, or “Team” page that lets donors know who is in charge. By introducing a sole member structure, you risk confusing donors if the relationship isn’t clearly defined. Donors, especially your biggest donors, do not want to call up a board member to discuss a major decision, only to learn there’s another entity the donor has never heard of that controls the board.

Board Member Dilemmas

Nonprofit board members are often more familiar with the for-profit world than they are the nonprofit sector. In a for-profit, board members owe their fiduciary duties to the shareholders and the organization. That’s not the way nonprofit law works for 501(c)(3) organizations. In a 501(c)(3), even one with members, the board members’ fiduciary duties are owed to the organization and, tangentially, the public. But we have heard from board members at nonprofits controlled by a sole member who are confused or frustrated by the ways in which they believe decisions that would be in the best interest of their nonprofit are at odds with the sole member’s interests. For instance, the sole member may believe that entering into a management agreement with the controlled nonprofit would be in everyone’s best interests, but board members at the controlled nonprofit think the management fees the sole member wants to charge are too high.

Placed in that position, the controlled nonprofit’s board members can feel helpless – stand up for what they believe are the best interests of the controlled nonprofit and they risk being removed from the board, but yielding to the sole member could be a breach of their fiduciary duty to their organization. While it’s a difficult choice, legally the board members owe their loyalty first and foremost to the controlled nonprofit on whose board they sit. You need to make sure that board members are fully briefed on their obligations, both to protect the organization and uphold their legal duties as board members.

Staff Confusion & Fear

When staff members see a new organization come in as sole member, it can create anxiety about how operations will change. Nonprofits should clearly message what functions will and will not change. Similarly, governance, HR, and oversight functions should be reviewed to see how to efficiently operate with closely related organizations. In some scenarios, leaving in largely separate systems might make sense, whereas in others the new sole member might displace a number of the controlled nonprofit’s overhead functions.

Related Party Transactions

Governance best practices, along with many state laws, require independent board members to carefully review related party transactions. Wherever the sole member enters into a major transaction with the controlled nonprofit, best practice would require that only independent directors should be involved in reviewing and approving those transactions. The board of the controlled nonprofit is under a legal obligation to make sure that the transaction is fair to, and in the best interests of, that organization. In many cases, however, there is reluctance among board members to treat transactions with the sole member as creating a conflict of interest. Often we hear that the interests of both organizations are aligned, and the controlled nonprofit is wholly dependent on the sole member, so board members think it does not make sense to treat a transaction with the sole member as a conflict of interest. This conflates practical considerations with legal ones – just because a controlled nonprofit needs the sole member doesn’t mean it should accept any transaction with the sole member without proper consideration of alternatives.

Strategies to Implement a Sole Member Structure     

Now that we’ve reviewed some common pitfalls, let’s talk about some relatively simple structural changes that can mitigate the possible downsides of a sole member structure. Remember, there are many reasons why a sole member structure can be beneficial. As with any governance decision, a sole member structure should be well-considered and tailored to the needs of each organization at which its implemented.

Staggered Boards and Limited Removal Rights

Nonprofits should balance the control of the board by the sole member with directors’ fiduciary obligations. One way to do that is to stagger board terms (for instance, three year terms with 1/3 of the board up each year) and place some limitation on the sole member’s right to remove directors. The sole member might still have the ability to remove directors, but that right can be limited to “for cause” removals or require ratification by a majority of the board. By insulating directors slightly from the sole member, directors will have the space to speak critically when they feel the organization is being led down the wrong path.

Independent Directors

Another possible solution is for certain board seats to be reserved for independent board members, individuals who are NOT appointed by the sole member. This will likely be limited to a small minority of the Board, but a small number of directors can play a big role in providing assurance to the whole board that transactions, including ones with the sole member, are in the best interests of the controlled nonprofit. Independent directors can also be useful barometers of the board’s performance and governance.

Clear Messaging

Internally and externally, the sole member and the controlled nonprofit should make sure it is clear how the entities are related and how they work together. Donors deserve to know if money given to one organization will end up supporting another organization (albeit indirectly). Regulators want to know that transactions are properly and fairly approved. Staff need to know to whom they are answering and who is setting policy internally.

In conclusion

Corporate sole membership structures can be useful to all everyone involved. They can help grow and manage complex organizations. Sole member structures can also mitigate legal exposure to their parent nonprofits. As with anything, board members should be prudent when contemplating a sole membership structure. Potential pitfalls can be mitigated by embedding certain structural safeguards to protect the controlled nonprofit’s independence, which should ultimately provide reassurance to the boards of BOTH organizations that a healthy corporate structure is in place.


 

[i] Where a corporate entity is the sole member and the corporate entity itself is owned or controlled by at least three people.

[ii] There are many other options (such as an LLC) that could accomplish this goal, but we won’t get into those in this article.

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